Recent Rulings Illustrate Creative Strategies to Deal with UBTI

Summary

From an investment standpoint, the Achilles' heel of charitable remainder trusts is unrelated business taxable income. The presence of even one dollar of UBTI will cause a CRT to lose its tax-exempt status for the entire tax year and be taxed as a complex trust. The effect of UBTI on a CRT can range from benign to catastrophic. In this article, Los Angeles attorney David Wheeler Newman reviews several recent letter rulings, all designed to avoid this potential investment trap.

Recent rulings issued by the IRS illustrate creative approaches that are being used to deal with the problem of UBTI (Unrelated Business Taxable Income) in CRTs (Charitable Remainder Trusts). Why is all this creative energy being focused on this problem? There are two linked reasons.

First is the increasing interest in alternative asset categories, including private equity, real estate, venture capital and hedge funds. Many of these investments seek higher returns with leverage, creating the likelihood that the returns will be UBTI of the debt-financed income variety. There is, of course, an old saying among tax advisors that taxable income is better than no income at all, which roughly translates in this situation to mean that if a portion of the higher yield is taxable as UBTI, then the alternative investment is compared on an after-tax basis.

The second reason, however, is that the stakes are much higher in the case of UBTI received by charitable remainder trusts. Unlike a foundation or university endowment, which pays tax only on UBTI, with other investment income remaining tax-exempt, a CRT will lose its tax exemption on all income -- UBTI and non-UBTI -- if it has any UBTI in the year. This effectively precludes a CRT from investing, say, 20% of its portfolio in alternative asset classes with the remainder in traditional stocks and bonds, since to do so would cause all income earned by the CRT from all sources to become taxable.

Controlled Foreign Corporation and UBTI

A recent series of four nearly identical private letter rulings, including Ltr. Rul. 200315035, address four CRTs, which set up and funded a foreign corporation established in a no-tax, offshore jurisdiction. The foreign corporation then invested these funds in US investment partnerships that produced debt-financed income.

To understand why the trustees of the CRTs might want to do this, one needs to know about a provision of US tax law targeted at US taxpayers investing through offshore corporations. That rule provides that certain classes of income, including the investment income earned by most alternative asset classes, are taxed immediately to the US shareholder, whether or not the income is distributed from the offshore corporation to the US shareholder.

This provision is designed to prevent US taxpayers from deferring tax on investment income earned through foreign corporations they control. But the interesting thing in this context is the character of the income that passes through to the US shareholders. Unlike the income of a partnership, which retains its tax character when attributed to its partners (again whether distributed or not), income of a controlled foreign corporation that passes through to its US shareholders is characterized by IRC § 951 as dividend income (although not qualifying dividends eligible for the 15% rate). Dividends, of course, are not UBTI. In these rulings the IRS confirmed that by making the alternative asset investments through the controlled foreign corporation, the CRTs effectively cleansed the income earned from those investments of its UBTI taint.

The Harvard Endowment Solution

Another series of private letter rulings, obtained by Harvard University and which includes Ltr. Rul. 200352017, takes a different approach. Like investment officers at other colleges, those at Harvard were frustrated that they had developed expertise in alternative asset investing, earning impressive yields for the endowment, but because those investments generate debt financed income, they were unable to hold them in CRTs. The solution would be to allow CRTs in which the college has an interest to invest in units of the college endowment, if there was a way to do so without generating UBTI to the CRTs. The technique Harvard came up with accomplishes this objective (although at price we will get to in a moment).

Harvard created a contractual obligation under which it would issue units in the endowment to a CRT. But the units would give the CRT only a contractual right to receive distributions from the endowment pro rata with other units, and the right to recover its investment in the units at the then-current value of endowment units, but no interest in the underlying investment assets of the endowment. The IRS ruled that payments received by the CRTs from distributions on, or redemption of, the units is not UBTI.

However, the IRS goes on to characterize for tax the endowment distributions received by the CRT with respect to its units as ordinary income, taxable at the highest rate. This characterization can have a major negative impact on the after-tax distributions received by beneficiaries from CRTs under the four-tier system of CRT tax accounting, since the income beneficiary loses the chance to receive qualified dividend income and long-term capital gain, each of which are taxable at a maximum federal rate of 15%, and tax-exempt income.

To evaluate the impact of this element of the ruling, one would need to compare the after-tax distributions to a beneficiary from a CRT invested in a typical diversified portfolio that does not produce UBTI, and includes publicly traded equities and bonds, with the after-tax distributions received from a CRT investment in endowment units under Harvard's configuration. One quickly reaches the conclusion that the return from the endowment would need to be substantially greater than the return from diversified portfolio in order for the income beneficiary to be better off with a CRT invested in endowment units.

[PGDC Editor's Note: The IRS has not yet published the most recent Harvard ruling approving this technique. Harvard University published the ruling in .pdf format. It has been transcribed here.]

Supporting Organizations

A final strategy to minimize the negative impact of UBTI is not relevant to CRTs, but instead applies to assets held to benefit the charity directly. The basic idea is that, in calculating UBTI, an entity exempt from tax under IRC § 501(c)(3) may reduce unrelated business income with certain deductions, including the charitable income tax deduction to calculate the net amount of UBTI that will be subject to tax. This gives grant-making charities, like foundations and supporting organizations, the ability to reduce the tax cost of earning income that is subject to UBTI. The amount of distributions to other charities that may be deducted is up to 10% of UBTI for charities organized as nonprofit corporations, and up to 50% for charities organized as charitable trusts.

To illustrate, assume a college organizes a supporting organization to receive gifts of real estate and other assets that might expose the college endowment to liability if received by the college directly. In this scenario a donor would contribute real estate to the college supporting organization (SO), which would sell the real estate and distribute the net sales proceeds to the college. If the real estate is encumbered by a mortgage that is treated as acquisition indebtedness, sale of the property will generate UBTI of the debt-financed variety. The SO may offset up to 50% of this UBTI with a charitable deduction as a result of the distribution to the college, effectively cutting the tax cost of UBTI in half.

This same trust-form SO could also be the vehicle through which the college makes investments in alternative asset categories, reducing the tax cost of the UBTI generated from these investments.

These three strategies illustrate an important planning concept: just because an investment might generate UBTI, that's not the end of the analysis. Creative planners might find a way to reduce or eliminate the tax cost of the UBTI.